Are business loans between family members a good idea?
For many business owners, 2020 has been an arduous year, involving shutdowns, layoffs, and significant lost profits. Although loans have been made available through government lending initiatives, your business or that of a family member may not qualify for them. Or perhaps you did receive a loan, but it wasn’t enough.
At this point, you may be eyeing family members as a source of capital. But family loans must be handled with care. If they aren’t structured properly, you could invite IRS scrutiny and harm the company’s ability to access capital in the future. Be sure to discuss the following issues with your professional advisors.
Pay attention to interest
Loans from family members should generally be treated like loans from outside investors or lenders. The loans should carry interest at no less than IRS prescribed rates, which currently are very low. For multiyear loans, the rate is set monthly by the IRS based on the number of years in the note. Demand loans — which have no stated term and thus are payable on demand — have a varying monthly interest rate. Keep in mind that loans must carry interest equal to the IRS rate. Otherwise, you’ll have to “impute” the interest at that rate.
Make sure family loan agreements are legally binding notes and establish a pattern of regular repayments. This information must be included in your company’s financial reports and company meeting minutes.
What if the business borrows money from a relative who’s also a shareholder? If the interest rate is less than the IRS-prescribed rate, the relative must treat the interest as a dividend or distribution. But if your relative has no ownership in your company, you can treat the interest as income with an offsetting interest expense instead of a capital contribution and distribution.
Avoid too much debt
For tax purposes, you may structure a transaction with a family member as an outright gift or as a loan. But be careful about borrowing too much. It can signal to bankers and potential investors that your business is financially unstable. In most cases, banks insist that any outside loans be subordinated to the bank’s senior debt. Plus, they generally review promissory notes to ensure they contain the appropriate provisions.
Businesses that are thinly capitalized, because most of their funds are from loans rather than from capital contributions, can send bankers and potential investors packing. In addition, if the IRS considers your family business’s debt to be high compared with its capital contributions, it may recharacterize the debts as equity, resulting in a disallowance of interest expense and higher corporate taxes. Further, treatment of payments to stockholders may be reclassified as dividends, possibly resulting in higher individual income taxes.
Make sure you examine your debt-to-equity ratio regularly to see whether you’re thinly capitalized. If your debt is still too high, you may need to take measures to withstand IRS scrutiny. Establish a pattern of reducing your debt-to-equity ratio during the year. This will usually satisfy the IRS that your company’s financial footing is sound. Also, consider replacing family debt (or other shareholder debt) with bank financing that’s guaranteed by family stockholders.
Get the right financing
Business loans from family members — particularly large loans — shouldn’t be made casually. Make sure you consult legal and tax advisors. They can help you evaluate whether a family loan makes sense given your business’s circumstances.